Later On

A blog written for those whose interests more or less match mine.

Why Private Equity Should Not Exist

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Matt Stoller is worth following. His most recent column begins:

Earlier this month, a former Toys “R” Us employee named Sarah Woodhams confronted Democratic Presidential candidate Julian Castro. Woodhams told Castro about her experience at the corporation. She worked there for seven years, and then was laid off with no severance because a set of private equity firms bought the company and looted it. What she described is not an isolated instance, but an increasingly common one in America. Woodhams told Castro that “dozens of retail companies controlled by Wall Street have gone into bankruptcy, including RadioShack, Payless, and Kmart,” with 15,000 jobs alone in Pennsylvania having disappeared.

“Billionaires buy up these companies, make huge profits on our backs, and get away with it because there’s no financial regulation,” Sarah Woodhams explained. “As president, what will you do to hold private equity firms and hedge funds accountable for the destruction of our communities and livelihoods?”

Partly because of organizing by workers like Woodhams, partly because of the scale of the industry, private equity is becoming an important part of the political dialogue. Millions of workers working for companies controlled by PE funds. As I noted above, the debate is now hot; Elizabeth Warren released a plan specifically on private equity, paralleled by a report on financial power by Republican Marco Rubio in March. More importantly, Castro was confronted by an activist. Castro was embarrassed because he did not seem to know what PE was, so you can be sure the other Presidential candidates are preparing talking points on PE for their bosses. That’s a big deal, when even the mediocre politicians start to get it.

So what is private equity? In one sense, it’s a simple question to answer. A private equity fund is a large unregulated pool of money run by financiers who use that money to invest in and/or buy companies and restructure them. They seek to recoup gains through dividend pay-outs or later sales of the companies to strategic acquirers or back to the public markets through initial public offerings. But that doesn’t capture the scale of the model. There are also private equity-like businesses who scour the landscape for companies, buy them, and then use extractive techniques such as price gouging or legalized forms of complex fraud to generate cash by moving debt and assets like real estate among shell companies. PE funds also lend money and act as brokers, and are morphing into investment bank-like institutions. Some of them are public companies.

While the movement is couched in the language of business, using terms like strategy, business models returns of equity, innovation, and so forth, and proponents refer to it as an industry, private equity is not business. On a deeper level, private equity is the ultimate example of the collapse of the enlightenment concept of what ownership means. Ownership used to mean dominion over a resource, and responsibility for caretaking that resource. PE is a political movement whose goal is extend deep managerial controls from a small group of financiers over the producers in the economy. Private equity transforms corporations from institutions that house people and capital for the purpose of production into extractive institutions designed solely to shift cash to owners and leave the rest behind as trash. Like much of our political economy, the ideas behind it were developed in the 1970s and the actual implementation was operationalized during the Reagan era.

Now what I just described is of course not the rationale that private equity guys give for their model. According to them, PE takes underperforming companies and restructures them, delivering needed innovation for the economy. PE can also invest in early stages, helping to build new businesses with risky capital. There is some merit to the argument. Pools of capital can invest to improve companies, and many funds have built a company here and there. But only small-scale funds really do that, or such examples are exceptions to the rule or involve building highly financialized scalable businesses, like chain stores that roll up an industry (such as Staples, financed by Bain in the 1980s). At some level, having a pool of funds means being able to invest in anything, including building good businesses in a dynamic economy where creative destruction leads to better products and services. Unfortunately, these days PE emphasizes the “destruction” part of creative destruction.

The takeover of Toys “R” Us is a good example of what private equity really does. Bain Capital, KKR, and Vornado Realty Trust bought the public company in 2005, loading it up with debt. By 2007, though Toys “R” Us was still an immensely popular toy store, the company was spending 97% of its operating profit on debt service. Bain, KKR, and Vornado were technically the ‘owners’ of Toys “R” Us, but they were not liable for any of the debts of the company, or the pensions. Periodically, Toys “R” Us would pay fees to Bain and company, roughly $500 million in total. The toy store stopped innovating, stopped taking care of its stores, and cut costs as aggressively as possible so it could continue the payout. In 2017, the company finally went under, liquidating its stores and firing all of its workers without severance. A lot of people assume Amazon or Walmart killed Toys “R” Us, but it was selling massive numbers of toys until the very end (and toy suppliers are going to suffer as the market concentrates). What destroyed the company were financiers, and public policies that allowed the divorcing of ownership from responsibility.

The Origins of the Model: Building a “Counter-intelligentsia”

If there is a father to the private equity industry, it is a man named William Simon. Simon is perhaps one of the most important American political figures of the 1970s and early 1980s, a brilliant innovator in politics, financial, and in how ideas are produced in American politics. Simon was an accountant, a nerd, but also an apocalyptically oriented conservative financier who was a bond trader and top executive at Salomon Brothers in the 1960s and 1970s. Beyond ruthless, Simon believed in ruthlessness as a moral philosophy. He was, according to a friend, “a mean, nasty, tough bond trader who took no BS from anyone,” and would apparently wake up his children on weekend mornings with buckets of cold water. He was such a difficult person that he was invited onto the Citibank board of directors, and shortly thereafter, essentially kicked off.

In the early 1970s, Simon went into politics, a leader at the Treasury Department under Nixon and Ford. He oversaw not just Treasury but became the the ‘Energy Czar’ in charge of the oil crisis, and a key player in rejecting New York City’s 1975 request for funds to ward off bankruptcy. Simon, along with a few others like Pete Peterson, came out of the Nixon administration with a better reputation than he had going in, perceived as a neutral and competent technocrat. Simon saw both prosperity and poison in Nixon and Ford. He supported the attacks on New York City’s and the forced austerity by the Federal government, but he also despised Nixon’s attempted economy-wide price controls to deal with inflation.

After his time at the Treasury, Simon turned to intellectual organizing, because he believed that the Republicans were soft. Simon though Republicans, even when they had power, as Nixon or Ford of Governors like Nelson Rockefeller of New York, were still liberal, operating as conservative Phyllis Schafly put it, merely “an echo” of the Democrats. So he sought to finance thinkers in academia to restructure how elites did policy, or as he put it, a “counter-intelligentsia.” He became the President of the Olin Foundation, the key conservative foundation providing money to the nascent law and economics movement, the conservative intellectual backlash against New Deal controls on finance and corporate power. Law and economics wasn’t perceived of as a right-wing institutional framework, but a scientific one. Olin gave to Harvard Law to build out a law and economics program, and financial supremacy over corporations was accepted quickly in liberal citadels.

The law and economics movement helped build the intellectual edifice for PE, a model designed to restructure the American economy from the very beginning. In 1965, Henry Manne, a law and economics organizer, wrote about the “market for corporate control,” putting forth financial markets where corporations were bought and sold as the essential mechanisms for firing inefficient managers and replacing them with ones who would look out for the owners.

In 1965, Manne was ahead of his time, because most people thought American businesses were well-run. But in the 1970s, in an inflationary environment and as foreign imports began coming into the U.S. in force, this belief collapsed. In 1970, Milton Friedman put forward the shareholder value of the firm, a theory that the only reason for the corporation to exist is to maximize shareholder value. In 1976, Michael Jensen, the intellectual patron saint of PE, refined these concepts into a paper titled “Theory of the firm: Managerial behavior, agency costs and ownership structure,” arguing that loading up firms with debt would discipline wasteful management, and that placing ownership in the hands of a few would force managers to be attentive to efficient operation of the corporation.

The increasingly widespread belief that American corporations were mismanaged, inflationary chaos, and a crisis of confidence among liberals combined into what was a political revolution in commerce. William Simon was both both a participant in and a moral light for this revolution. In the mid-1970s, he (or his ghostwriter) put pen to paper, and wrote a book popular among members of “the new right” as the large class of 1978 Congressional Republicans (which included a young Newt Gingrich) was known. His book was called A Time for Truth, and along with Robert Bork’s Antitrust Paradox, it gave the New Right a language to marry morality and political economics. Reagan would run on New Right themes in 1980.

A Time for Truth reflected Simon’s hardcore attitude. It was a jeremiad, with terms tossed around like ‘economic dictatorship’, charges of Communism and fascism, and a screed about the perils of government. The book was introduced by the intellectual godfather of the right-wing, the Austrian economist, F.A. Hayek, who lauded it as “a brilliant and passionate book by a brilliant and passionate man.” Simon popularized the pseudo-scientific term, ‘capital shortage,’ or the the idea that businesses simply didn’t have the incentive to invest in factories because of government rules or fear of inflation. This led to inflation, lower productivity, and stagnation. The solution would be simple: cut capital gains taxes, cut government spending, reduce antitrust enforcement, and stop regulating through public institutions.

The Carter administration and Congressional Democrats took Simon’s advice, and slashed capital gains taxes, cutting the maximum rate to 28% from 49% in 1978. They deregulated trucking, finance, airplanes, and railroads. In addition, changes in pension laws enabled American retirement savings to flood into new vehicles, like venture capital and its cousin, what would first be known as leveraged buy-outs and then private equity. The Reagan administration’s further deregulation of finance enabled a long bull market in the 1980s as speculators took control of the economy. Shareholders no longer were content to leave their money in stocks that paid dividends, because they could now keep most of their capital gains. And the chaos unleashed by deregulation opened up the door to corporate restructuring of corporations who had been tightly controlled by public rules, but were now free to enter and exit new businesses.

In 1982, William Simon turned into a leader of the financial revolution. He pulled off the first large scale leveraged buyout, of a company called Gibson Greeting cards, a deal that shocked Wall Street. He and his partner paid $80 million for Gibson, buying the company from the struggling conglomerate RCA. The key was that they didn’t use their own money to buy the company, instead using Simon’s political credibility and connections to borrow much of the necessary $79 million from Barclays Bank and General Electric, only putting down $330,000 apiece. They immediately paid themselves a $900,000 special dividend from Gibson, made $4 million selling the company’s real estate assets, and gave 20% of the shares to the managers of the company as an incentive to keep the stock price in mind. Eighteen months later, they took Gibson public in a bull market, selling the company at $270 million. Simon cleared $70 million personally in a year and a half off an investment of $330,000, an insanely great return on such a small investment. Eyes popped all over Wall Street, and Gibson became the starting gun for the mergers and acquisitions PE craze of the 1980s.

Another business trend intersected with changes in policy encouraging financial dominance: the rise of management consulting. Like law and economics, management consultants rose in the late 1960s with pseudo-scientific theories about business, and they began treating corporations as financial portfolios, with subsidiaries of assets. Many of the organizers of private equity firms in the 1980s came from management consulting firms like the Boston Consulting Group and McKinsey. Mitt Romney was an early innovator around PE. He came from Bain, which was a consulting firm. To give you a sense of what that meant in terms of the philosophy of commerce, here’s Bain Consulting today, helping companies find ways to innovate around raising prices instead of productive techniques. . .

Continue reading. There’s a lot more.

Written by LeisureGuy

31 July 2019 at 8:32 am

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